N°23-36: Economic Consequences of Banks’ Use of their Discretion over the Accounting and Regulatory Treatment of Investment Securities

The current accounting and regulatory framework grants banks considerable discretion in the treatment of investment securities. We show that banks' use of this discretion increases the information asymmetry reflected in their equity prices. In addition, we find that this source of bank opacity contributes to individual bank risk and systemic risk in the financial sector. To address endogeneity concerns, we apply a two-stage instrumental variable approach, which confirms our conjecture. Our results highlight important unintended economic consequences of the current accounting and regulatory framework for investment securities.